Economic Recovery Speculation

Yesterday was a major turning point in the economy, at least from the perspective of the Federal Reserve; in a 9-1 vote the Fed decided to taper off the bond buying program, a move that theoretically signifies a stable recovery post recession.

According to CNN Money, “The Federal Reserve predicts the economy will grow 3% next year, marking more solid, but still not robust, improvement ahead.” [1]

But are we really in a stable recovery? And what exactly does that mean?

There are a few data points that we can consider to weigh this; Here are the items I will be discussing:

  • Stock market performance
  • Industrial sector performance
  • Inflation
  • Current Bank Lending Activity
  • Unemployment and Job Growth
  • Wage increases

Stock Market Performance

Year to date, the S&P 500 index is up 29.61% and the Dow Jones Industrial Average is up 23.38%. According to Reuters on November 22nd:

Stocks rose on Friday, with the S&P 500 closing above 1,800 for the first time and healthcare names leading the way higher.

The Dow industrials ended at another record high above 16,000.

Both the Dow and the S&P 500 recorded their seventh straight week of gains in what has been a very strong year for stocks. The seven-week advance comes just ahead of December, which since 1950 has been the best month for both the Dow and the S&P. [2]

      On the optimistic side, this can be viewed as a result of increased confidence in the market by investors, possibly stemming from increased consumer confidence generating higher sales performance. However, pessimistically or pragmatically, it may be due to increased amounts of speculation in the market which may drive up risk.

As a cautionary note concerning the potential impact of Fed bond buying roll backs, on December 16th USA TODAY reported:

What will the market impact be when the Fed starts to dial back on QE?

     Savita Subramanian, head of U.S. equity and quantitative strategy, BofA Merrill Lynch: The net impact could be less negative than what might be expected. Tapering might be good news, in that it shows the economy is self-sustaining and less reliant on this consistent funnel of liquidity from the Fed. We could see a market rotation similar to what we saw from May to September, when we had a preview of what the impact of tapering might look like (when the Fed first hinted that tapering was coming).

     We got a little bit of a hiccup in the market, and we saw about a 5% correction. And that might be what we would expect in an actual taper scenario. The markets had some time to digest this.The taper appears to be almost inevitable, and it is just a question of when. We could see a sell-off and some volatility around it, but I don’t think that we will see a steep downside risk. [3]

Industrial Sector Performance

According to CNN Money, “Economic growth picked up recently. The housing sector — which got us into this mess in the first place — is bouncing back. Home sales, prices and construction are all on the rise. Auto sales recently had their strongest growth since 2006.” [1]

On Wednesday, Market Watch reported cautious optimism regarding the recovery after Ford Motor Company released expected pretax profit drops of up to 18% in the near future. But what got me the most about this article, was the graph they included:

“The chart shown here should give some food for thought: It shows what percentage of industrial production is from the auto sector.

In the data going back to 1971, it’s never been this high, with automotive production representing nearly 10% of the gross value of what U.S. industry produces.

It clearly can’t be this good forever. At some point, this auto boom in a country where people are increasingly living in cities and have less use and desire for vehicles will run its course” writes Steve Goldstein of Market Watch. But what are Americans buying these cars with when average wages for the middle and lower income brackets have only increased by 1% this year?

He continued, “Can the U.S. economy survive that? Well, it just may. Overlooked data points in the November jobs report include the gains in the diffusion index, for both the private sector overall and for the manufacturing sector in particular. What that means is there’s an increasing number of industries that are expanding their hiring.

Other statistics, like the Institute for Supply Management’s manufacturing series, also are on the upswing.” [4]

Furthermore, according to Reuters and the Commerce Department, the housing sector is set for a major come back:

WASHINGTON — Builders began construction on the highest number of new homes in nearly six years in November, a sign of strength in the economy that underscores the Federal Reserve’s decision to start tapering off its economic stimulus campaign.       

The Commerce Department said on Wednesday that housing starts jumped 22.7 percent last month from October, the biggest increase since January 1990, to a seasonally adjusted annual rate of 1.09 million units. That was the highest level since February 2008. [5]

However one question arises from this: how are Americans paying for new homes following the crash, when real wages have not increased significantly? The answer would seem to be that consumer confidence is rising, and more and more Americans are willing to take on longer mortgages with faith that the economy will pick up. This strategy of increased optimistic buying, when the employment outlook and salaries of most americans have not significantly increased, may be a recipe for disaster in the near future.

Inflation

On Tuesday, NPR’s John Ydtsie noted that “many economists and investors think there’s a good chance… [the] Federal Reserve policymakers will announce that they’ll begin reducing their $85 billion monthly stimulus, their third round of quantitative easing, or QE3.” And they were right, however the article cited two key cautionary reasons the Fed may have been considering not taper off the bond buying program. [6] These reasons can be taken as an indication of a weak economic recovery and a period of uncertainty.

First, they discussed inflation rates, and second and possibly equally as important, they expressed concern over current bank lending activity – which I will cover in the subsequent section of this article.

For the first part NPR quoted University of Chicago professor and former Fed governor Randy Kroszner as saying, “Inflation being far below where the Fed wants it to be is a major reason why they may hesitate”. The article continued:

Princeton economist Alan Blinder points out that, strangely, during a period when the Fed has pumped trillions into the financial system, inflation has drifted lower. Binder said, “Inflation has in fact fallen on average over the last five years”.

“Blinder, a former vice chairman of the Fed, says this falling inflation is an extraordinary development given the trillions the Fed has pumped into the financial system. Economics textbooks say that’s a recipe for inflation.”

To clarify, the article’s author wrote, “The most recent measurement shows that core inflation in a basket of consumer goods through the 12 months ending in October was running at just 1.7 percent. That’s below the Fed’s target of 2.0 percent, and it’s been drifting downward this year.’

But why is the Fed’s target 2.0 percent for inflation? How is the rate of inflation correlated with the strength of the recovery?

According to Investopedia:

Low or no inflation, theoretically, may help an economy recover from a recession or a depression. With both inflation and interest rates low, the cost of borrowing money for investments or borrowing for the purchase of big ticket items, such as automobiles or securing a mortgage on a house or condo, is also low. These low rates are expected to encourage consumption, say some economists…

The U.S. Federal Reserve, which sets interest rates on government securities – mid- and long-term Treasury notes and shorter-term bills – has promised to keep rates at very low levels until 2014.

This assurance of low rates for the next two years is designed to stimulate the economy and keep inflation rates at a guaranteed level. The business community, including large, medium and small operations, know that certain fixed costs will remain constant, at least for that designated time period.

Businesses can therefore plan their borrowing, hiring, marketing, improvement and expansion strategies accordingly. Investors, likewise, know roughly what government and corporate bonds and other debt will return, since most of these instruments – if not so-called junk bonds – are pegged to Treasury yields.
However, economists differ notoriously in their opinions. Some economists claim that a 6% inflation rate for several years would help the economy by helping to resolve the U.S. debt problem, lifting wages and stimulating economic growth. [7]

A side note on the most recent inflation statistics: The U.S. Bureau of Labor Statistics (BLS) has stated that “The Consumer Price Index for All Urban Consumers (CPI-U) was unchanged in November on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 1.2 percent before seasonal adjustment.” [8] CPI-U is most commonly used to chart the rate of inflation for the average person. The 1.7 percent rate that Ydtsie mentioned comes from the CPI less food and energy, a number more often looked at by economists, but not one that is felt as much by the average consumer.

For more information on CPI, varying forms, and what it means see: http://stats.bls.gov/cpi/cpifaq.htm#Question_1

Current Bank Lending Activity

To look at current bank lending activities, I’m going to go back to what NPR put out on Tuesday. The author asked “what happened to that $85 billion a month — $1 trillion total — that the Fed has pumped into the financial system over the past year”?

“It all got bottled up in the banks, and essentially none of it … got lent out,” Blinder says.

He says the banks are the key to making quantitative easing work. It would work by the Fed announcing it wants to buy $85 billion each month in government bonds and mortgage-backed securities. Blinder says banks would then line up to sell them, and the Fed pays the banks by putting money in their reserve accounts at the Federal Reserve.

“You can think of these as the deposits that banks hold at the Federal Reserve, which is a bank for them,” he says.

But unless the banks lend those deposits, or invest them, they don’t get into the economy, they don’t enter the money supply, and they don’t contribute to inflation. And if banks aren’t lending, there’s no boost to the economy, either, which is, after all, the Fed’s main goal.

Why Aren’t Banks Lending?

“This is the $64 trillion question — the deep, deep mystery to me,” Blinder says. “In bits and pieces, we understand that, but I think in large measure we don’t understand it.”

Blinder says one part we do understand is that the banks were burned by the financial crisis and are much more cautious about lending. Another factor, he says, is that the banks have some incentive to leave their reserves safely at the Fed, because the central bank pays them interest. It’s only a quarter of a percent annually, but Blinder thinks the Fed should stop doing that to encourage banks to lend.

Randy Kroszner thinks there is a different reason banks aren’t lending.

“I think there’s just relatively low demand from small- and medium-sized businesses right now for borrowing,” he says.

That’s also what a recent survey from the National Federation of Independent Businesses found.

But what if the economy picks up? Banks and businesses become more confident, lending booms, and the trillions in bank reserves begin moving into the economy. Both Blinder and Kroszner say the Fed has the tools to remove the reserves safely before inflation flares.

Policymakers could begin the process at Tuesday’s meeting by deciding to dial back the $85 billion in monthly stimulus. [6] 

I posited yet another reason to friends on Facebook yesterday, on why banks may not be lending easily right now.

From my own speculation, and what has been common talk among investors recently, is that the banks may be hoarding cash specifically with the intent of purchasing assets or securities when prices drop in coming instability or a crash. Keep in mind that the recovery right now is widely viewed to be below the pace that was most commonly expected, which is making many investors (banks included) cautious.

Think of it this way, your greatest opportunity to buy low to later sell high arises when assets take a huge drop in their price, but you can’t buy them if your money is tied up in other temproarily illiquid assets such as stocks when everyone else is selling. You can’t cash out fast enough without taking a huge loss that ultimately degrades your ability to sieze that moment. The banks know this, and they felt it in 2008. It is extremely difficult to quickly reposition vast amounts of wealth in a quick downtrend.

Fed Chairman Bernanke’s hesitation to back off the bond buying program this long, and with a tapering off, can be viewed as an indication that the recovery is weak – along with low inflation rates. If it backslides, there will be a golden opportunity for banks to invest in “under valued assets” that they were unable to take advantage of in 2008 due to less conservative strategies.

Remember this:
“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett

Unemployment and Job Growth

CNN Money wrote yesterday that “Unemployment is the lowest in five years…[but] there are those who still cannot find work: About 11 million Americans remain unemployed, and 37% of them have been out of a job for at least six months.”We continue to be very concerned about the long-term unemployed,” said Secretary of Labor Tom Perez. “Their problems persist.””

Additionally, the article noted “workers’ wages are up only about 1% from a year ago, making it harder for average folks to make ends meet. Union-led strikes by fast-food workers are on the rise.” [1]

According to BLS unemployment statistics, the unemployment rate hit an all time low for the past 5 years this month. However, the labor force participation (LFP) rate in October hit the lowest level since 1978 at 62.8% – that’s the number that counts people who have a job and those who are looking for a job. With the LFP being at 63% in November, that leaves a sizeable chunk of the population opting out of working and not actively seeking a job – for a myriad of reasons.

On the right, Republicans have been quick to blame low LFP rates on laziness or frustration with the current economy due to government policies. On the left, Democrats have blamed corporations for not hiring enough new employees, thereby ratcheting up cometition for the remaining job openings, and increasing senses of hopelessness toward finding a job. Baby boomer retirement and seasonal unemployment also come into play for this number, but these alone should not be enough to set a record low since 1978.

The point is clear that if the economic recovery was more robust, with more job openings and increased earnings, the LFP number should theoretically decrease and wages should also rise. Since that is not the current case, recent unemployment and job growth statistics can be taken as an indication of a weak recovery.

Conclusion

By most estimates the current economic recovery appears to remain quite weak, not a break out recovery. There are a few positive elements occuring right now, such as a rallying stock market, increased performance in a few specific industries, lower unemployment, and the Federal Reserve’s vote of confidence by tapering off QE3. However, we appear to be not quite out of the woods yet, with perplexingly low inflation rates, banks not lending as much as was hoped for by the Fed, industry rallies driven mostly by consumers such as with houses and automobiles, and by a high level of the population not actively seeking work.

An additional note, to be covered in a following article, is the negative impact of Washington’s bipolar politics – Chairman Bernanke has blamed the lack of a robust recovery several times on stiff “fiscal headwinds”. Whether this is the culprit or not, and whether Republican or Democrat policies would better aid the recovery, is clearly open to much debate – but the point is, on top of what we have discussed so far, Washington’s rhetoric isn’t helping.

Sources Cited

1. http://money.cnn.com/2013/12/18/news/economy/economy-outlook/index.html

2. http://www.reuters.com/article/2013/11/22/us-markets-stocks-idUSBRE9AA0IH20131122

3. http://www.usatoday.com/story/money/markets/2013/12/15/investment-roundtable-qa-fed/3986871/

4. http://articles.marketwatch.com/story/ford-warning-signals-us-economy-needs-new-leadership-2013-12-18?link=MW_story_latest_news

5. http://www.reuters.com/article/2013/12/18/us-usa-economy-idUSBRE9BF0XF20131218

6.  http://www.npr.org/2013/12/17/251796694/year-in-numbers-the-federal-reserves-85-billion-question

7. http://www.investopedia.com/financial-edge/0212/inflation-and-economic-recovery.aspx

8. http://www.bls.gov/news.release/cpi.nr0.htm

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